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© 1999 American Accounting ^sociation Accounting Horizons Vol, 13 No, 4 December 1999 pp- 399-412 COMMENTARY Peter D. Easton Peter D. Easton is a Professor at Ohio State University and a Professorial Fellow at the University of Melbourne. Security Returns and the Value Relevance of Accounting Data INTRODUCTION Empirical market-based accounting research seeks evidence of the value relevance of accounting data via anaiysis of the relation between these data and various market varia
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  © 1999 American Accounting ^sociation Accounting Horizons Vol,  3  No,  4December 1999 pp-  399-412 COMMENTARYPeter D Easton Peter D Easton is a Professor at Ohio State University and a Professorial ellow  at the  University  of Melbourne Security Returns and the ValueRelevance of ccounting Data INTRO U TION Empirical market-based accounting research seeks evidence of the value relevanceof accounting data via anaiysis of the relation between these data and various marketvariables. The decade of the 1990s witnessed an increasing use of  price  per share andmarket rate of return as the market variables of interest. The focus of this commenttiryis on regressions of price per share on the levels of various financial statement data(referred to herein as price-levels regressions ) and regressions of returns on changesin these financial statement variables (referred to herein as returns regressions ).The main points in the commentary Eire:ã  Studies that use returns of the  fiscal period  as the market  metric provide evidence regarding the  role  of  accounting  data as a summary of events  that have affectedfirms over the reporting period. In contrast, studies of the market response duringa very short interval around the time of the announcement of the accounting dataexamine the role of these data in providing information to investors about eventsthat may affect their perceptions of the firm.ã  An  argument  for returns as the market metric: ã Theoretical models that form a foundation for the use of security prices  as  the mar-ket metric also provide a foundation for using rate of return as the market metric.ã Returns regressions may be used as the basis for tests of hypotheses regardingthe timeliness of the reporting of value changes in  fin ncied  statements.' ^ The concept of timeliness  oUhe accounting summary  is the extent to which the value change as reportedin the financial statements is contemporaneous with the change in market value. This difFers from theconcept of timeliness of  accounting information  that relates to the investors' use of the information insetting prices.These comments are based on my presentation at the American Accounting Association Doctoral Consor-tium in Lake Tahoe in June 1999 and at the American Accounting Association/Taiwan Accounting Associa-tion First Globalization Conference in Taipei in July 1999.1 thank Keji Chen, Kirk Philipich, Terry Shevlin,Greg Sommers, and, especially, Jim Ohlson and Gary Taylor for comments on an earlier draft of the paper,and Tae Hee Choi for assistance in preparation of the graphs herein.  ^^^ Accounting Horizons December 1999 ã  Regressions that use price as the dependent variable suffer from potentially seri-ous scale  problems.  An obvious means of overcoming the scale or per share efTectis to rely on the returns specification.ã  Insights from the  scatter plot  of returns and earnings: ã Recent increases in the power and availability of software facilitate detailed inspection of the huge data sets often encountered in market-based accounting re-search providing evidence beyond that from regression analyses.ã  A  scatter-plot of returns and earnings shows distinct nonhnearities in the relationbetween these variables and provides insights regarding recent studies of these non-linearities (including Hayn  1995;  Basu 1997; Burgstahler and Dichev 1997).  CCOUNTING D T S SUMM RY OF EVENTS Ball and Brown (1968) and Beaver (1968) show that net income is value relevant inthe following senses. Beaver (1968) shows that the market reacts with increased trad-ing volume and increased price variability in the week of the earnings announcement.Ball and Brown (1968) show that earnings increases (decreases) are associated (on av-erage) with positive (negative) abnormal returns over the 12 months prior to the earn-ings announcement—in short, the unexpected component of earnings tends to have thesame sign as unexpected price changes. These seminal studies and much of the work inthe subsequent two decades emphasized the relation between the new information inearnings and either the market reaction to this information (as in Beaver 1968) or theassociation of this new information and the unexpected or abnormal component of re-turns (as in Ball and Brown 1968). This information perspective, which has continuedto influence research methods in the last decade, may be described as an investor, auser, or a finance perspective that views accounting as a source of information for use(either actual or potential) in investment decisions.Studies such as Beaver (1968) that focus on the market response at the date of theannouncement of the accounting data (that is, the market metric is measured over arelatively short interval—a few days or a few hours) examine the role of accountingdata in providing information to the market about events that may affect investors'perceptions of the  firm ^  In contrast, the association between unexpected or abnormalreturns and unexpected earnings in Ball and Brown (1968) provides evidence of therole of accounting as a summary of the unexpected events that have affected the firmover the 12-month period prior to the earnings announcement.More recent studies have tended to move away from the information-content per-spective and to focus more clearly on the view that fmancial statements are a summaryof the events that have affected the firm over the fiscal period for which the report hasbeen prepared. This perspective is similar  to  that in much earher studies such as Patonand Littleton (1940) and Edwards and Bell (1961). Empirical studies that adopt thisperspective require a benchmark against which to evaluate the effectiveness of theaccounting summary. Since the events that have affected the firm over the  fiscal  periodare captured in change in firm value (or returns), market returns are the obviousbenchmark.Easton et al. (1992) argue that there are two reasons why earnings will not be aperfect summary of events of the corresponding return interval:  1)  value-relevant events - Other prototypical representations of the information-content perspective are Patell and Wolfson(1984), Wilson (1986) and Easton and Zmijewski (1989), all of which focus on the investor reaction atthe time of the announcement of accounting information.  Security Returns and the Value Relevance of ccounting Data  401 observed by the market (and therefore captured in returns) in a prior period may affectaccounting earnings of the current period, and (2) value-relevant events observed by themarket in the current period may not be repori;ed in accounting earnings of the currentperiod. In short, accounting reports the effects of economic events with a lag. Easton et al.(1999) show that in a return-earnings regression, the omitted variable that arises due toaccounting recognition lag is perfectly negatively correlated with the included variable(accounting earnings). The effect of this omitted variable is to bias the estimate of theearnings coefficient (and, implicitly, the regression  R^ toward zero— ceteris paribus  a lowerearnings coefficient and/or a lower  R^  suggests that earnings are a poorer summary of theevents that have affected returns of the fiscal period.^ The effect of this lag is that the R''from a regression of returns on eeirnings will be less than 1.At any point in time, price reflects all returns (that is, changes in market value)since the firm came into existence, while book value represents all accounting mea-sures of change in value (earnings) during this period. Book value will reflect the cumu-lative effect of accounting reporting lag—some of the value-relevant events observed bythe market (and therefore captured in returns) in early years will be included in ac-counting earnings of later years, hut some will remain unrecorded in book value. Theeffect of this accounting reporting lag in the price-levels regression is similar to theeffect in the returns regression—the  R^  will be less than 1.Most of the following discussion adopts the perspective that accounting data maybe viewed as a summary of the events that have affected the firm although some com-ments will be made regarding the information-content perspective.  SIMPLE MODEL As a starting point, consider a firm with two types of assets—those for which wewould (as a first approximation or best guess ) use book value as the basis for determiningmarket value and those for which we would use earnings as the basis for determiningvalue. The following simple model provides the valuation of this firm.''Consider the following rationale for using book value as the basis for determiningmarket value. Today's market value (per share) represents entitlements to a flow, orseries, of expected dividends. Likewise, the accounting book value (per share) repre-sents the accountant's measure of the firm's resources and commitments that togetherwill determine the expected dividend flow per share. Assume (initially) that the bookvalue per share of firm j at time t  B.^)  perfectly records the value of a share in the sensethat it is equal to the market value of the share  (P.^).  That is;We can also rationalize a relation between market value per share and earnings pershare. If firm i's earnings for period t represent earnings of each future period in ' This effect of accounting recognition lag is similar  to  the effect of  stale earnings in Kothari and Zimmerman H995).  However, since the emphasis in Kothari and Zimmerman (1995) is on obtaining an unbiasedestimate of the coefficients relating prices to earnings and returns to earnings, the bias in the returnsregression is seen as misspecification. In contrast, when the research emphasis is on the validity of earn-ings as a summary variable, the effect of this omitted variable (that is, the events that are  not  summa-rized by earnings) is precisely the focus of the investigation.* The early partof this discussion uses some of Brown's (1994) description of the ideas presented in Eastonand Harris (1991).  ^^^  Accounting Horizons /December 1999 perpetuity, and these earnings are paid out as dividends in the period in which theyaccrue, then, cum-dividend price per share  (P.,   d.,) is a multiple of earnings per share (X^).  That is:P,-fd,  =  (l  +  rX (2)where r. is the expected rate of return on shares of firm i.Now assume that a proportion k of the assets of the firm (human capital and otherintangibles may be examples of these assets) may be valued using model (2) and aproportion  1  - k) of the firm s assets may be valued using model (1) (property, plant,and equipment may be examples of such assets). Firm value may be determined as: Pn:  =  (l-k)B,  +  k[(l  +  fJ)X,-dJ. (3)Ohlson (1995) provides a rigorous foundation for equation (3) in a dynamic uncer-tain environment that relies on the clean surplus assumption and the Miller andModigliani (1961) propositions. In this framework, variables other than book value,earnings and dividends play a role in valuation. These variables are captured by thescalar  v^^^  and the valuation relation is:P.t  = 1  - k)B, -f- k  [ 1  -f f;)  X^  - dJ   av^^. (3a)Ohlson s (1995) work is cited as the theoretical foundation for many recent studies ofthe relation between price, book value (and components of book value), and earnings(and components of earnings). These studies are based on variations of the followinglinear (price-levels) regression:^An important contribution of Ohlson s (1995) work is that it forms a framework forunderstanding the relation between prices and accounting data and a basis for interpret-ing estimates of the regression coefficients a^,, a,, and  a^ For example, (a) the modelprovides a valuation role for other information and dividends—a nonzero intercept a^suggests that the average incremental explanatory power for prices (over book valueand earnings) is nonzero,  b)  the coefficient  a^  on  book  value is negatively related to thepersistence in abnormal earnings  so  that a higher coefficient  on book  value implies thatthese earnings are less persistent, and, (c) the coefficient  a^  on earnings is positivelyrelated to this persistence and negatively related to the expected rate of return.^ Note,however, that Ohlson (1995) is only a starting point for understanding the relationbetween prices and accounting data. Other theoretical papers (including, Feltham andOhlson 1995; Ohlson and Zhang 1998; Zhang 1999) provide critical additional insights.For example, Feltham and Ohlson (1995) form a framework for understanding the roleof conservative accounting, while Zhang (1999) shows,  inter  alia that with growth andconservative accounting, the coefficient on book value may, indeed, be negative.Although Ohlson (1995) provides obvious motivation for price-levels regressions,the model also provides motivation for returns regressions. Taking first differences in The effect of treating dividends as part of the random error term is unclear. Hand and Landsman (1998)address this issue in the context of a price-levels regression. The effect of other information, v , is ana-lyzed in detail in Ohlson (1998) and Dechow et al. (1999).Abnormal earnings is the earnings less the required rate of return on beginning book value.
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